How Should the U.S. Regulate Housing Finance After the 2008 Crisis?

Traditional regulatory oversight may have been just what the housing finance industry needed in the lead-up to the financial crisis in 2008. Yet instead of regulating housing finance through traditional command-and-control legislation, housing finance in the U.S. was primarily “regulated” at the time through the public provision of housing capital. This use of a “public option”—where the government assumed the role of a private market—worked for a time but by the turn of the new century the underlying market conditions had shifted, necessitating an altogether different regulatory approach.

In “Regulation or Nationalization?: Lessons Learned from the 2008 Financial Crisis,” Adam J. Levitin and Susan M. Wachter trace the rise and fall of the public option as a regulatory approach to U.S. housing finance, explaining why the public option ultimately failed to prevent the 2008 financial crisis.

Starting in the 1960’s and continuing through the 2000’s, the housing finance market in the United States became progressively more privatized, and no new regulatory framework was created to address the risks that this privatized market created.

Levitin, a law professor at Georgetown University, and Wachter, a real estate and finance professor at the University of Pennsylvania’s Wharton School, suggest that in the future the implementation of some traditional command-and-control regulations will likely be necessary to ensure the functioning and stability of mortgage markets, whether these traditional regulations are in combination with a public option or not.

As Levitin and Wachter show, the public option first arose in the housing finance arena during the Great Depression when the government entered the housing finance market to offer liquidity and insurance to financial institutions, seeking to encourage them to lend.  Initially, the Federal Home Loan Bank and Federal Savings and Loan Insurance Corporation were formed.  The Home Owners’ Loan Corporation (HOLC) and Federal Housing Authority (FHA) were later created to address some of the problems created by the first two institutions.  The HOLC purchased defaulted mortgages from financial institutions and refinanced them in an attempt to clear markets without foreclosure, which eventually led to government ownership of a huge percentage of mortgages.  Refinancing through the HOLC was intended to be a temporary public option, but led to several long-term effects, including the initial realization of the long-term, fully-amortized, fixed-rate mortgage as the federal government standard and the standardization of other mortgage lending procedures.

Since the government did not have the desire to hold on to the mortgages long-term, the FHA was created to insure mortgages against credit risk, which made mortgages more marketable to private investors.  Because mortgages had to meet certain requirements to become FHA-insured, this became another means of regulation through standardization, since investors were largely unwilling to purchase non-insured mortgages.  Levitin and Wachter highlight that the standardization of mortgage terms was  important to the creation of a secondary mortgage market.

In 1938, Fannie Mae was the first institution created in this secondary market.  Fannie Mae purchased insured mortgages in exchange for long-term fixed-rate debt securities that were backed by the U.S. government.  The exchange relieved sellers of mortgages of credit risk because Fannie Mae was a government corporation.  Fannie Mae thus created liquidity for mortgage originators.  The creation of a secondary market reduced regional discrepancies in interest rates and financing availability, and Fannie Mae continued the work of HOLC and the FHA in establishing the 20% down-payment, 30-year fixed-rate mortgage as the standard product of the U.S. housing finance system.

Regulatory oversight of the housing finance system became reliant on what products the government-sponsored enterprises were willing to buy and the FHA was willing to insure. However, starting in the 1960’s and continuing through the 2000’s, the conditions needed for public option to work as a regulatory scheme started to change.  With the privatization of Fannie Mae, creation of Freddie Mac, and the crash of the savings and loan industry, the limited regulation that had existed under the public option approach proved to be woefully inadequate.

The inadequacy of the public option became even clearer with the privatization of secondary mortgage markets, which started including riskier and non-standard mortgage products.  The prior regulatory approach became defunct, according to the Levitin and Wachter.  While the housing finance market expanded rapidly from the New Deal up through the financial crisis of 2008, regulatory oversight in this field decreased, instead of becoming stronger, with the increased competition and “race to the bottom” in underwriting and pricing standards that came with privatization.

After the 2008 crisis, the public option is back.  Just as when it was first created, the public option approach of today has arisen as an inadvertent byproduct of financial collapse, instead of through a deliberate process. As the reliance on the public option declines in the years ahead, a regulatory system that is reliant on command-and-control regulations and Pigouvian taxation will become necessary.  However, if a hybrid approach is chosen, and public options compete with private actors, the authors argue that traditional and uniform regulatory oversight will still be needed.  In that case, regulators must ensure that all actors are competing under the same sets of rules, and that there is no race to the bottom among the private actors in a hybrid housing finance market.

Levitin and Wachter’s paper appears as a chapter in the recently published book, Regulatory Breakdown: The Crisis of Confidence in U.S. Regulation, edited by Cary Coglianese and published by the University of Pennsylvania Press.